United States
2003 Article IV Consultation-Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
05 Aug 2003
eISBN:
9781451839609
Language:
English
Keywords:
ISCR; CR; yield; deflation risk; monetary policy report; financial markets development; monetary policy; U.S. dollar; current account; federal funds rate; economic growth; Current account deficits; Global
Download PDF (491.8 KB)

Despite repeated shocks, the United States economy has provided valuable support for global growth. Executive Directors commended this development, and stressed the need to tighten fiscal and monetary policies. They welcomed the assessment of the fiscal transparency Reports on Observance of Standards and Codes that the United States has set in areas of fiscal transparency. They urged the authorities to strengthen the financial position of the Social Security and Medicare system. They demanded the United States to play a leadership role in promoting an open multilateral trade system.

Abstract

Despite repeated shocks, the United States economy has provided valuable support for global growth. Executive Directors commended this development, and stressed the need to tighten fiscal and monetary policies. They welcomed the assessment of the fiscal transparency Reports on Observance of Standards and Codes that the United States has set in areas of fiscal transparency. They urged the authorities to strengthen the financial position of the Social Security and Medicare system. They demanded the United States to play a leadership role in promoting an open multilateral trade system.

I. Introduction and Overview

1. The 2003 consultation took place against the backdrop of heightened uncertainty about the strength of the recovery. After experiencing one of the largest stock market declines in the post-war period and then falling into recession in early 2001, the economy was buffeted by a series of further shocks, including the September 11th attacks, major corporate failures, additional stock price declines, and the war in Iraq. Remarkably, productivity growth has remained robust; the rise in the unemployment rate has been relatively modest; and large corporate bankruptcies were absorbed without a systemic impact on financial intermediaries. Nevertheless, the recovery has been uneven and sluggish.

2. The weak economy and security concerns have overshadowed policy making and significantly undermined the fiscal position. Despite an aggressive easing of monetary policy, economic slack has increased and deflation has now become a concern. On the fiscal front, the policy focus has been on tax cuts, fiscal stimulus, and—since the September 11th attacks—boosting security-related spending. As a result, the fiscal surpluses that were achieved over the course of the 1990s have given way to large deficits, complicating the task of dealing with impending demographic pressures.

3. Against this background, discussions centered on:

  • Managing short-term risks. With the substantial deterioration in the fiscal outlook, and inflation low, monetary policy should bear the principal responsibility to respond if the recovery does not regain momentum.

  • Re-establishing a sustainable fiscal framework. The additional stimulus introduced this year leaves the fiscal position even less well prepared to cope with impending demographic pressures. The priority remains to establish a credible framework for delivering a balanced budget, excluding Social Security, over the medium-term and to place retirement and health care systems on a sound financial footing.

  • International perspectives. The U.S. economy has helped support global growth in recent years, but the eventual correction of imbalances related to large fiscal and current account deficits could impose costs on the rest of the world. On trade issues, strong U.S. leadership is needed toward forging deep and broad-based liberalization in the Doha Round.

4. U.S. officials remarked that U.S. policies had been broadly consistent with Fund advice over the years, which mainly reflected a shared philosophy about the importance of sound and market-oriented policies. Differences of view remained, however. While the authorities had broadly agreed last year with the staff on the need for medium-term fiscal consolidation, the weak economy and national security had been seen as more immediate priorities. The authorities did not share the staff’s long-standing concern regarding the U.S. current account deficit, which they considered mainly a reflection of weak growth abroad and, therefore, not a U.S. policy matter. Although staff has expressed some specific concerns in recent years regarding U.S. trade actions, officials emphasized the overall U.S. commitment to multilateral trade liberalization.

II. Recent Economic Developments

5. Following a relatively shallow downturn in 2001, the economy has staged an uneven recovery (Tables 1, 2, and 3). Despite a massive collapse of equity prices and business investment, the 2001 recession was mild and short-lived, with output dropping by only ½ percent in the first three quarters. Thereafter, a series of shocks began to weigh on activity, including: the September 11th attacks; major accounting scandals and business failures; further declines in stock prices; and geopolitical uncertainty and higher oil prices during the run-up to the Iraq war. As a result, the recovery has been lackluster, and growth slowed again to an annualized rate of 1¼ percent during 2002Q4–2003Q1 (Figure 1).

Figure 1.
Figure 1.

United States: Cyclical Comparisons 1/

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

1/ Previous recessions defined as the average level during the December 1969, November 1973, January 1980, July 1980, July 1990, and March 2001 recessions, normalized to 100 at the trough, as defined by the National Bureau of Economic Research. The trough of the 2001 recession is assumed to be 2001Q3.

United States: Selected Indicators of Economic Activity

(Percent change from previous period, unless otherwise indicated)

article image
Source: Haver Analytics.

Contribution to growth.

As a share of GDP.

6. As a result of slow growth, employment has stagnated, economic slack has continued to rise, and inflation has fallen to near postwar lows. Private nonfarm payrolls remained 2¾ percent below their early 2001 peak in June 2003. The unemployment rate rose sharply from a 30-year low of just under 4 percent in early 2000, but remained in the 5½–6 percent range during most of 2002 and early 2003. However, the unemployment rate jumped to 6¼ percent in June. (Figure 2). Although strong productivity growth in recent years has left measures of potential output subject to considerable uncertainty, most estimates suggest the output gap widened to around 2½ percent in early 2003 (Figure 3). With slack increasing, the core CPI inflation rate has trended downward to under 1½ percent, a level not seen since the mid–1960s.

Figure 2.
Figure 2.

United States: Employment

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

Figure 3.
Figure 3.

United States: Output Gap and Prices

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

7. The economy’s recent loss of momentum occurred despite exceptional support from monetary and fiscal policies. Although the dollar’s strength and the drop in stock prices have weighed on indicators of financial conditions, monetary easing has been unprecedented. The federal funds rate target was reduced by a cumulative 475 basis points during 2001, a further 50 basis points in November 2002, and an additional 25 basis points in June 2003. As a result, long-term bond yields have fallen close to post-war lows (Figure 4). On the fiscal front, substantial reductions in income tax rates were legislated in June 2001; March 2002 legislation increased investment incentives and extended unemployment benefits; defense and security-related spending was increased significantly in 2002 and 2003; and substantial additional tax cuts were legislated in May 2003. These measures contributed to a massive shift in the federal government’s unified budget from a surplus of 2½ percent of GDP in FY 2000 (October–September) to a deficit likely to reach almost 4 percent of GDP in FY 2003, a 5 percentage point turnaround in structural terms.

Figure 4.
Figure 4.

United States: Interest Rates

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

8. Private consumption has remained remarkably resilient, owing to income gains, low interest rates, and the housing market boom. During the two years ending May 2003, real disposable income rose by 7¼ percent, over half of which reflected tax cuts and higher unemployment benefits. In addition, productivity gains facilitated strong growth of labor incomes, as hourly wage increases more than offset employment declines. Lower mortgage rates and higher home prices prompted record refinancing, which reduced interest payments and freed up home equity for consumption and debt repayment.1 Discounting by auto and other manufacturers also mitigated the effects of higher energy prices. As a result, households managed to maintain consumption, spur strong growth in residential investment, and still boost their saving rate from 2 percent in mid-1999 to around 3½ percent in early 2003.

9. By contrast, the recovery in business fixed investment has been tentative. Purchases of equipment and software plummeted from historical highs relative to GDP during 2000–01, but began to recover in the last three quarters of 2002, supported by a rebound in profits and the replacement of IT equipment purchased ahead of Y2K. Through much of 2002, inventory restocking also provided a substantial boost to activity. However, confidence in the underlying strength of investment demand was dampened by a renewed drop in business equipment and software purchases in the first quarter of 2003, and a sharp increase in industrial vacancy rates continued to weigh on nonresidential structures investment.

10. Weak investment has reflected the uncertain strength of corporate profits and balance sheets. Profits began to recover in early 2002, spurred by a 4¾ percent surge in productivity—the fastest annual rate in over 50 years—and a concomitant 2 percent decline in unit labor costs (Figure 5). Cash flows also benefited from lower interest rates and investment incentives introduced in March 2002. However, the investment rebound has been considerably weaker than in past recoveries, and profit growth has been disappointing, partly owing to a sharp rise in pension and health care costs. Default rates on commercial bank lending have eased somewhat, but remain elevated, and corporate debt remains close to nearly 50 percent of GDP (Figure 6).

Figure 5.
Figure 5.

United States: Labor Productivity

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

Figure 6.
Figure 6.

United States: Corporate Sector Debt

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

11. Some sectors suffer particularly severely from high debt loads, long-standing structural problems, and declining output prices. Cash flows in the auto, industrial machinery, and steel-using (fabricated metals) industries remain particularly weak, and significant losses have been registered in the transportation and communications sectors. In many of these industries, employee defined-benefit pension plans are also severely underfunded, and increased employer contributions have further dampened profit growth.

12. Weak demand abroad and the earlier strength of the U.S. dollar represented an additional drag on the recovery. Export volumes began to recover modestly in 2002 from their sharp decline in preceding years, but fell again toward the end of the year and in early 2003. Capital goods exports were particularly weak owing to sluggish investment abroad. By contrast, import volumes rebounded strongly in 2002, reflecting purchases of consumer goods and industrial supplies, before dipping in 2003Q1. With higher world oil prices, the current account deficit reached a record 5¼ percent of GDP in 2003Q1 (Figure 7 and Table 4).

Table 1.

G-7: Economic Performance

article image
Sources: World Economic Outlook database; and IMF staff estimates

Composites for the country groups are averages of individual countries weighted by the average value of the respective GDPs converted using PPP weights over the preceding three years.

On national accounts basis.

Table 2.

United States: Selected Economic Indicators

(Percent change from previous period, unless otherwise indicated)

article image
Sources: Haver Analytics; and IMF staff estimates.

Contribution to growth.

NIPA basis, goods and services.

Table 3.

United States: Key Indicators

(Percent change from previous period, unless otherwise indicated)

article image
Sources: Haver Analytics; and IMF staff estimates.

Monthly data derived from Census data; quarterly volume and prices derived from NIPAs; current values obtained from BOP.

Table 4.

United States: Balance of Payments

(In billions of U.S. dollars)

article image
Source: Haver Analytics.
Figure 7.
Figure 7.

United States: External Sector

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

13. Investor concerns regarding the U.S. trade imbalance and interest rate differentials have weighed on the dollar since early 2002 (Figure 8). After appreciating by 30 percent in real effective terms during 1999–2001, the dollar has weakened sharply against the euro and Japanese yen from February 2002 (Figure 8). In real effective terms, the decline was more moderate—around 10 percent to early June 2003—since the dollar remained strong vis-à-vis Latin American and Asian currencies. As a result, staff estimates suggest that the dollar is still some 20 percent above levels consistent with medium-term fundamentals.2

Figure 8.
Figure 8.

United States: Exchange Rates

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

14. The dollar’s decline has been associated with a drop in private capital inflows for purchases of corporate securities and direct investment. However, increased purchases of dollar reserves by foreign central banks and lower U.S. investments abroad helped finance the large current account deficit (Figure 9). The U.S. net foreign liability position reached 23 percent of GDP by end-2002, from under 5 percent of GDP in the early 1990s.

Figure 9.
Figure 9.

United States: Global Net Inflows

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

15. The increased risk aversion that weighed on bond and equity markets in 2002 and early 2003 appears to have lifted (Figure 10). In 2002, stock prices fell sharply on news of the collapse of Enron and WorldCom and a scaling back of profit forecasts, and corporate bond spreads widened. Market sentiment remained weak in the run-up to the Iraq war, but has since improved considerably. The S&P 500 index rose by nearly 15 percent during April–May, and spreads have narrowed significantly since the beginning of 2003. With U.S. stock prices roughly 35 percent below their early 2000 peak, valuations now appear broadly in line with historical norms.

Figure 10.
Figure 10.

United States: Price-Earnings Ratio

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

III. Policy Discussions

A. Economic Conditions and Prospects

16. The staff projects activity to gather momentum in the latter half of 2003, with GDP growth rising from around 2¼ percent in 2003 to 3½ percent in 2004. Consumer sentiment has improved with the quick end to the Iraq war, and household demand would also be supported by additional tax cuts, the rebound in stock prices, low interest rates, and the easing of oil prices. These same factors, as well as strong productivity growth, are also expected to allow profits and business fixed investment to gather momentum into 2004. The drag from net exports would wane into 2004, reflecting a gradual strengthening in partner countries and the lagged effects of the dollar’s depreciation, and the current account deficit would start to narrow somewhat from around 5 percent of GDP in 2003. With economic slack remaining significant, CPI inflation is projected to fall to around 1¼ percent in 2004, before rebounding somewhat as the output gap closes.

Medium-Term Projections

(Percent change from previous period, unless otherwise indicated)

article image
Sources: IMF staff estimates; and Haver Analytics

17. The mission agreed that the longer-term growth potential of the U.S. economy remained strong. Federal Reserve officials considered that labor productivity gains since the downturn only partly reflected labor shedding and efforts by businesses to cut costs. The economy’s performance of recent years provided ample evidence that the efficiency gains of the 1990s were not illusory. In their view, consensus estimates of U.S. long-term productivity potential of 2–2½ percent could be conservative.

18. Discussions focused on the tenuous nature of the short-term recovery. Treasury officials agreed that 2003 growth was likely to be less than the 3 percent rate assumed in the FY 2004 Budget and closer to the staff’s projection. The weaker outlook reflected the economy’s difficulty in working off the combined effect of the collapse of equity prices and the shock to confidence from the corporate scandals of 2001–2002. Although low interest rates, the drop in oil prices, higher defense spending, and recent tax cuts were expected to provide a substantial lift to activity, more subdued scenarios could not be ruled out.3

19. Treasury and Federal Reserve officials agreed that business fixed investment represented the principal risk to the outlook. Most studies suggested that only a modest capital overhang had emerged at the beginning of the downturn, but other factors appeared to have weighed on investment including: high levels of excess capacity, geopolitical uncertainties and its impact on risk-taking, rising health care and energy costs, and the need to fund defined benefit plans (Box 1). Although credit conditions and corporate balance sheet restructuring favored a strong rebound of investment, a sustained improvement in business confidence and profits was also needed.

20. Officials viewed the risks to household demand as more modest. The strength of consumption through the downturn was broadly consistent with low interest rates, strong wage growth, the surge in housing prices, and tax cuts. Household balance sheets did not exhibit signs of stress—delinquency rates were modest and debt service burdens were not excessive. The personal saving rate had already responded to the decline in household net wealth, and further adjustments were likely to be gradual (Box 2).

21. While recognizing that housing prices were showing signs of overheating, officials discounted the possibility of a collapse. Some urban areas had seen rapid growth in market values, and prices were at the upper end—or even somewhat above—of ranges consistent with underlying fundamentals (Figure 11).4 However, the housing market was considered to be relatively insulated from speculative excess; loan-to-value ratios remained comfortable; households were locking in mortgages at low, long-term rates; and market turnover appeared orderly. While the rate of price increase would likely slow in the near future, outright declines were a low probability, except possibly in selected markets. Although an upturn in long-term interest rates posed risks to the housing market, such an event would most likely occur in the context of a broader improvement in economic activity that would provide offsetting support to the market.

Figure 11.
Figure 11.

United States: Housing Prices and Affordability

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

Capacity Utilization and Investment

The U.S. capacity utilization rate declined sharply during 2001 and has yet to show convincing signs of a turn-around. Moreover, while some other measures of economic slack—such as the unemployment rate—have fared better than in previous cyclical downturns, capacity utilization in the current recession remains considerably lower than in many past recessions, with the exception of the early 1980s.

uA01fig01

Capacity Utilization

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

The dispersion of capacity utilization rates across industries has also been high. Presently, the rate ranges from the low 60s in the high-tech industries to the high 80s in the petroleum and coal industries. Measured in terms of a weighted standard deviation, the dispersion across industries has reached levels not seen since the early 1980s.

These developments have raised the question whether the low level of capacity utilization will weigh on investment going forward. In particular, a number of analysts have argued that firms are unlikely to invest in plant and equipment until capacity constraints become more pressing.

Simple statistical analysis does suggest that capacity utilization influences future investment. The correlation between investment and the capacity utilization rate (with lags of up to four quarters) is in the range of 0.4, and simple bivariate tests also suggest that capacity utilization does “Granger-cause” growth in investment but not the reverse.

uA01fig02

Dispersion of Capacity Utilization

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

Although these results raise doubts about the likely strength of investment spending in the near term, there are offsetting considerations. The statistical relationship between capacity utilization and investment is usually considered to reflect the impact of other factors, including profits and other growth indicators. Moreover, most analyses suggest the absence of a significant capital overhang. The business sector capital/output ratio (including equipment and structures) declined for most of the 1990s, and at just over 120 percent at the end of 2001, is below the average of the last half century. Staff estimates indicate that while a modest overhang in computer equipment emerged at the end of the 1990s, this would have been absorbed relatively quickly, given the recent drop in investment and the rapid depreciation rates of this type of equipment.1 Moreover, the average age of equipment in the manufacturing sector, remains relatively high—at 8.3 years for equipment and software. Finally, the industrial sector only accounts for about 17 percent of GDP, so that industrial capacity utilization rates do not necessarily reflect developments in the broader U.S. economy.

uA01fig03

Private Capital Stock

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

1C. MacDonagh-Dumler, “Evaluating the Evidence of a Capital Overhang in the U.S. Economy,” United States: Selected Issues, Country Report No. 2/165 (August 2002).

Is the U.S. Saving Rate Too Low?

U.S. household wealth has fallen significantly since 2000, raising concerns that household demand may be withdrawn in order to restore savings. Household net worth has fallen sharply between 2000 and 2003—by approximately $4 trillion, or 9 percent. Casual inspection of the relationship between the saving rate and household net worth suggests that a decline in wealth of this magnitude would lead to an increase in personal saving of around 4 percentage points. The actual rise in the saving rate has been much more modest, however—less than 2 percentage points, from 2 percent in 2000Q1 to around 3½ percent in 2003Q1.

The slow pickup in saving so far can be partly explained by a different response of saving to the accumulation of different types of wealth. A long-run model of consumption, income, and wealth was estimated—where wealth was measured in three categories: housing, equity, and non-equity financial wealth (demand deposits, bonds, and other forms of liquid wealth).1 The results suggest that saving is about 3–4 times more responsive to changes in non-equity financial wealth than to changes in either residential or equity wealth. This higher responsiveness may be due to the more liquid nature of non-equity wealth, which means that it can be drawn down quickly, if needed.

uA01fig04

Household Wealth and Saving

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

Model predictions suggest that the personal saving rate is only about ¾ percentage points below its estimated equilibrium level. While equity wealth fell by around $8¼ trillion between 2000–2003, housing wealth rose by about $3¼ trillion, and nonequity financial wealth increased by $2½ trillion. Deposits and money market mutual funds accounted for much of the growth in non-equity financial wealth, as the stock market decline led households to redirect savings into less risky assets and to attempt to lock in capital gains. As a result, the long-run equilibrium saving rate was estimated to be about 4½ percent in 2003Q1, only modestly above the actual saving rate of 3½ percent.

uA01fig05

Personal Saving Rates

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

However, more abrupt adjustments to the saving rate cannot be ruled out. For example, if the economy were to falter, asset classes that have, to date, dampened losses in the equity market—especially residential housing—could come under pressure. Moreover, the model partly explains the decline in the U.S. saving rate over the past decade in terms of a trend decline, likely reflecting financial innovation, and it remains to be seen whether this trend will be sustained.2

1See the Selected Issues paper for details.2Financial innovation was seen as an important contributor to the decline in the personal saving rate in previous staff work. See Cerisola, M. and P. De Masi, 1999, “Determinants of the U.S. Personal Saving Rate,” United States—Selected Issues, IMF Staff Country Report No. 99/101.

22. Officials acknowledged that state and local governments were under significant fiscal stress, which was likely to act as a further drag on activity.5 Most states were facing a third consecutive year of budget difficulties—mainly the result of a sharp drop in tax receipts. State governments were expecting financing gaps of around ¾ percent of GDP in FY 2004, with state employee pension plans also being significantly underfunded. States had largely exhausted the scope for using extra-budgetary funds to meet their balanced budget requirements and had already taken steps to boost fees, freeze salaries and hiring, reduce services, and curb payments to health care providers. Even with the federal aid recently legislated by Congress, more painful cuts in services and tax increases would be required.

23. Officials viewed the weak global environment as a key risk to the domestic outlook. They noted that partner country growth projections had been marked down much more significantly than for the United States and that net exports would likely act as a drag on U.S. demand. Moreover, the dollar’s depreciation had been relatively modest in real effective terms, and the U.S. current account deficit would likely remain high in the near term.

24. Federal Reserve officials highlighted that deflation was a small but important risk.6 Core inflation indices measured on an annualized 3-month basis had fallen to around 1 percent in recent months, already close to zero, after subtracting measurement biases of around ½ percentage point (Figure 12). The recent decline—which partly reflected shocks to the relative price of durables and imports—was larger than could be explained by the Fed’s statistical models—and with an output gap presently in the range of 2 percent or higher—inflation could fall further. However, outright deflation seemed unlikely in view of the monetary and fiscal stimulus in the pipeline, the fact that inflation expectations seemed well anchored, and the support to prices that would come from the dollar’s weakness and recent increases in commodity prices and employment costs.

Figure 12.
Figure 12.

United States: Inflation Trends

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

B. Monetary and Exchange Rate Policies

25. Recent policy statements by monetary policymakers have signaled increased concern regarding the outlook. The Federal Open Market Committee (FOMC) took the unusual step in its May 2003 statement of suggesting that while the risks to growth were balanced in the near term, “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup.” The statement was perceived by markets as reflecting a heightened concern regarding deflation and suggesting that further easing was in store. As a result, longer-dated yields fell and markets started pricing in at least a further quarter point cut in the federal funds rate target. Indeed, at its late June meeting, the FOMC re-affirmed its concern regarding a possible further decline in inflation and lowered its target for the federal funds rate 25 basis points.

26. The Federal Reserve officials explained that the FOMC’s recent statements reflected a view that a deflationary spiral was a low-probability, but high-cost, event. Although relatively benign periods of price declines could occur in the face of favorable productivity or other supply shocks, policy makers were very mindful of the corrosive effects that sustained deflation could have on balance sheets and the effectiveness of conventional monetary policy instruments. With inflation already at a very low level and the output gap likely to remain wide for some time, the economy would be exposed to significant cumulative risk of a large demand shock pushing inflation into negative territory.

27. In discussing the possible merits of further easing, the mission asked whether the sluggish recovery suggested that the interest rate channel for monetary policy had weakened. Officials agreed that activity had been disappointing, especially given the significant monetary and fiscal stimulus that had been injected, but they did not view this as evidence that conventional monetary policy instruments had lost traction. Indeed, the strength of housing investment and durable goods purchases confirmed that the usual transmission mechanism remained effective. However, overall financial conditions had not been as supportive of business investment and external demand, especially given the dollar’s earlier strength, heightened risk aversion, and the level of stock prices (Figure 13).

Figure 13.
Figure 13.

United States: Monetary Policy Indicators

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

1/ Goldman Sachs index, which is a weighted average of real interest rates, stock market capitalization, and the real effective exchange rate.

28. Federal Reserve officials expressed confidence that policy instruments would still be available even if short-term interest rates approached zero. If necessary, the Fed would inject liquidity, to expand the size of its balance sheet, and would also operate at different points on the yield curve. The expectations channel also represented a potent instrument, as illustrated by the drop in long-term bond yields following the May FOMC meeting.

29. Nonetheless, Federal Reserve officials stressed that there were good reasons to avoid having to test these unconventional instruments. Most importantly, there was no U.S. experience regarding the quantitative impact of monetary policy close to the zero interest rate bound. Moreover, even moving close to the zero bound could have potentially important adverse microeconomic effects. In a low interest rate environment, money market spreads would become compressed and make it difficult for intermediaries to cover their costs.

30. Staff and Federal Reserve officials agreed that these factors argued for pre-emptive action to avoid deflation. The Japanese experience, in particular, illustrated the importance of demonstrating at an early stage a commitment to avoiding deflation. To this end, U.S. policymakers had actively sought to re-assure markets that the FOMC recognized the potential risks and was prepared to act.

31. The authorities saw little advantage to stating a quantified medium-term inflation objective, since the FOMC’s inflation objectives were well understood. The FOMC’s May statement had set a lower bound to its definition of reasonable price stability by signaling a preference to avoid seeing inflation fall further from its present level of around 1 percent. Moreover, surveys and spreads on inflation-indexed bonds showed that expectations were already well anchored. A more specific statement of the Fed’s objectives would risk eroding credibility, since the Fed did not have the instruments to hit a particular numerical inflation target exactly and—at times—might wish to give priority to stabilizing economic activity. They acknowledged, however, that opinions varied among the FOMC’s members on this issue, and if deflation pressures intensified, interest in this approach might increase. Moreover, the recent experience may have persuaded FOMC members to consider a somewhat higher rate of inflation as consistent with the definition of price stability.

32. The team noted the recent weakening of the U.S. dollar and expressed concern that the large U.S. current account deficit created risks of disorderly adjustments. Especially given the weakening of public saving, the U.S. current account deficit seemed likely to remain at a high level and take the U.S. net foreign liability position to over 40 percent of GDP by 2008. Against this background, the dollar still seemed over-valued relative to medium-term fundamentals, and a correction—especially if it were triggered by weaker confidence in U.S. productivity rather than stronger growth abroad—could adversely affect both the United States and partner countries. Key channels would be: a significant increase in borrowing costs for U.S. firms; an erosion of competitiveness for foreign producers; and substantial capital losses on foreign holdings of U.S. assets.7

33. U.S. Treasury officials stressed that recent exchange rate movements had been orderly and that there had been no change in the authorities’ policy approaches. The fact that the dollar’s depreciation had been accompanied by rallies in bond and stock markets demonstrated continued confidence in the U.S. economy. Moreover, the dollar’s buoyancy since the mid-1990s mainly reflected a market response to the strength of U.S. macroeconomic performance. Thus, in their view, as long as the exchange rate did not reflect policy missteps, the current account deficit was not a cause for concern. The authorities also dismissed the possible need for foreign exchange market intervention, since even coordinated intervention tended to have little sustained effect.

34. Federal Reserve officials also saw little risk of disorderly adjustment, while acknowledging that the present current account deficit would be difficult to sustain. Deficits of this magnitude would imply rapid increases in U.S. net foreign liabilities, requiring a willingness by foreigners to continue to increase their share of U.S. assets. As investment income outflows increased, an ever-larger correction in the trade balance and exchange rates would eventually be necessary to service external debt and stabilize the net liability position.

C. Fiscal Policy

35. Fiscal policy discussions took place against the backdrop of the Congressional debate over the Administration’s February 2003 Budget and tax cut proposals. Following two years of unprecedented fiscal stimulus, the Administration’s FY 2004 Budget called for further increases in the fiscal deficits reflecting:

  • Tax cuts— Proposals included the elimination of the double taxation of dividends, the acceleration of earlier-scheduled reductions in marginal tax rates, and an expansion of tax preferences for savings.

  • Spending increases—Proposed increases in outlays for Medicaid, income security, and a prescription drug benefit under the Medicare program would be only partly offset by assumed cost savings from improvements in the administration of Social Security (Figure 14). Discretionary spending—spending requiring annual Congressional appropriations—would grow 1¼ percent faster than in the current services baseline over FY 2004–FY 2008, driven by increases for defense and homeland security, while other discretionary spending would decline in real terms.

Figure 14.
Figure 14.

United States: Federal Outlays, FY 2004–2008

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

Budget Projections

(In percent of GDP)

article image
Sources: FY 2004 Budget of the U.S. Government; and IMF staff estimates.

36. Congress has moved swiftly to implement many of these measures (Box 3). In April, an $80 billion supplemental spending bill was approved, aimed mostly at covering the cost of the Iraq war. In May, the bulk of the Administration’s tax proposals were legislated, as well as extended unemployment insurance benefits and aid for the states. Although the ten-year cost of the package was placed at only$350 billion, this reflected the inclusion of “sunset” provisions that would cause the tax cuts to begin to expire as early as in 2005. Congress is also now considering legislation to expand Medicare benefits, at a cost of $400 billion over ten years.

Recent U.S. Tax Initiatives

Significant tax cuts were legislated in April 2001. The measures included: an immediate 1 percentage point reduction in personal income tax rates for most brackets, and further 1 percentage point cuts in 2004 and 2006; a gradual elimination of the estate tax by 2010; phased increases in the child tax credit; and tax relief for married couples phased in over 2005–2009. The ten-year cost of the measures was held to $1.35 trillion by phasing them in gradually and allowing them to expire after 2010.

Further tax cuts were proposed in February 2003 as a part of the Administration’s FY 2004 Budget. The measures were estimated to cost a cumulative $1.3 trillion over FY 2004–2013, and included:

  • An economic growth package that would bring forward to 2003 the previously-scheduled reductions in marginal tax rates, increases in the child tax credit, and marriage penalty relief; eliminate the double taxation of dividends; and provide temporary tax incentives for businesses investment. Cost: $726 billion over FY 2004–FY 2013.

  • Other tax incentives, including measures to encourage saving, charitable giving, and health care; unemployment insurance reform; and tax simplification. Cost: $114 billion.

  • Permanent extension of expiring tax provisions, including the 2001 cuts. Cost: $588 billion.

The Jobs and Growth Tax Relief Reconciliation Act of May 2003 contained most of the Administration’s growth package. However, dividends were not fully excluded from personal income tax, and the measures were made subject to sunsets in order to contain the total cost to $350 billion through FY 2013. The package included:

  • Dividends and capital gains—The tax rate on capital gains was lowered to 15 percent and was applied to dividends. A 10 percent rate for low-income households was to be reduced in phases to zero percent for low-income brackets by 2008. These measures would expire after 2008.

uA01fig06

Scheduled Dividend Tax Rates

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

  • Personal income tax rates—The tax rate reductions scheduled for 2004 and 2006 were brought forward to 2003, lowering brackets from 27, 30, 35, and 38.6 percent to 25, 28, 33, and 35 percent, respectively. However, the rates would revert to pre-2001 levels after 2010. The expansion of the 10 percent income bracket scheduled for 2008 was also brought forward to 2003 but would expire after 2007.

  • Marriage penalty—The standard tax deduction for married taxpayers filing joint returns was increased to 200 percent of that for single taxpayers beginning in 2003 but would expire after 2004.

uA01fig07

Scheduled Child Tax Credit

Citation: IMF Staff Country Reports 2003, 244; 10.5089/9781451839609.002.A001

  • Child tax credit—The child tax credit was increased from $600 to $1,0